Is DCF useless?

I had a discussion with a guy that claimed he had 5+ years of professional experience in trading, equity research, portfolio construction, and he insisted that DCF valuation of companies is useless. He said that DCF is only good for things like bonds with very stable and predictable cash flow, while DCF for a company requires too much “guessing”. Instead, he uses his own approach with 5 types of analysis (although he admitted that he uses target prices provided by research firms, so basically he still indirectly uses DCF to some extent) and his returns at least two times better than S&P 500 (but he refused to tell any risk-adjusted measure of performance).

I know that DCF is part of CFA level 2 curriculum and I skimmed some textbooks on valuation and I know that there are 3 approaches to valuation (dcf,relative valuation, contingent claim valuation) and each one of these approaches has its constraints and cannot be used in some cases, but I had an impression that DCF is nevertheless a go-to approach to valuation. However, I am outsider to the investment industry so I am still wondering whether DCF is really becoming obsolete and it’s one of those things you learn in college but (almost) never use in real life. So my question to those of you who is professionally involved in companies’ valuation: Is this guy right? Is DCF useless?

dcf is not useless. in fact it is the cornerstone of all investing.

when you buy an investment wheter a bond or stock, you are essentially hoping that the cash flow you receive at different points in the future will be greater than what you paid today plus interest (discounting factor).

he is right that is is more accurate for bonds as the cash flow is more predictable, but you are still gambling on rate of inflation/interest, the quality of the bond issuer, the attractiveness of other investments (for example if stocks have a dividend yield of 10% vs bond rates at 2%). but the idea that it is not useful for stocks just because of hte difficulty of predicting cash flow is stupid. a good investor is suppose to price that predictability.

one could say that inputting 1 scenario and calling it a day is dumb. you should be able to put multiple assumptions and create a range. for example you cant assume a growth company will grow 20% to perpetuity, like all companies they slow, but when do they slow. at what number do they start becoming stable. and then after that you have to predict its slow to sharp decline. because given its growth rate in terms of income, you’ll get a certain multiple. etc etc.

lastly play with inputs enough and you’ll start to get a rough idea on what anything is worth without doing a dcf.

DCF is not very popular especially for mature companies because of lot of subjectivity involved in deciding inputs. For such companies trading multiples are more preferred. However for early stage, high growth companies DCF is used which takes multiple growth periods into consideration. Nevertheless investment banks use both multiples and DCF based approaches to value stocks and then take either simple average or weighted average of prices (by assigning weights to each method).

Thank you for your answer!

"in fact it is the cornerstone of all investing. "

That’s what I thought, so I was very surprised by his opinion on DCF for stocks.

Thank you, mskhan91!

Dcf and multiples are no different. The multiple just abstracts away all the assumptions so it makes people feel better

Yeah, DCF and multiples are somewhat interchangeable, the multiple itself is analogous to the effect of the discount rate. That said, there are a lot of shops that aren’t big on DCF’s and their applicability can vary between firms given their scenarios. He’s not “wrong” and I don’t think you’re “wrong” either.

Thank you, rawraw !

Thank you, Black Swan!

Do they use only multiples? what if multiples are inapplicable for some reason? Or do they have their own proprietary approach that is not based on discounting?

Some do. I can’t think of a situation where multiples wouldn’t work, particularly if DCF works. For high growth tech companies sometimes they fall back on sales multiples, a lot of places will back out from an EBITDA multiple.

That’s interesting, i have to read up on multiples and interchangeability of dcf and multiples.

Thank you.

If you are a DCF guy and want to talk to a multiple guy and not feel silly, just calculate justified multiplies that contain the assumptions that matter the most

Basically you have to realize that in formulating a multiple, you are selecting between EBITDA, Earnings or some other base that carries certain assumptions and the target multiple incorporates aspects like risk and growth. In this way, the target model is obviously subjective, but what many new analysts don’t initially grasp are that the risk premiums, betas and long term growth rates embedded in DCF models are largely subjective and in many senses the process of selecting those metrics is very similar to the “art” of selecting a multiple. Both DCF and model valuation are ultimately going to reflect analyst assumptions.

I wouldn’t describe myself as DCF guy and my opponent as multiple guy. For the purpose of above-mentioned discussion I am sort of “why-is-he-so-extremely-negative-about-dcf-that-seems-unprofessional” kind of guy and my opponent is “dcf-is-rubbish-for-fools-i-invented-a-method-with-5-types-of-analysis” guy.

Good advice for the future though, thanks.

I understand that rates, etc are subjective, at least I think I understand :slight_smile: I’m not against multiples per se, just don’t feel that that dcf deserved such negative attitude because of subjectivity and imprecision, as if the alternative is 100% accurate. Besides, it wasn’t dcf vs multiples argument. That guy invented his own method with 5 types of analysis, and multiples approach is only one of the 5, another 4 remain unknown and only god knows how subjective and precise the remaining 4 are.

I swear, I think nearly every stock I’ve bought using a DCF model (not that many) I’ve built has tanked. The ones that I go off Warren B’s questions (do i understand the business, does it have a durable competitive advantage, does it have a good management team, and is it priced right) do well. For that last question, I look at how the company has done over the last 10 years or so, since the recession, and use a few basic multiples.

FWIW, that’s how I invest my hard earned personal money and family money. Right or wrong, that’s my skin in the game. On the job, I model pretty extensively and honestly, I don’t see the value add. I used to be a big believer too, took courses and all. Maybe I’m a bad modeler, I dunno. Some people will say you can use it to sensitize but you can do that with multiples and the story in your head, at least that’s what i do.

Thank you for sharing your experience!

If I understand correctly, on the job you use dcf. Do those stocks also tank?

Ironically enough, the guy I’m talking about also thinks that Buffet’s value investing approach doesn’t work any more. Actually, it was the discussion of Buffet that led to dcf.

Yes they have LOL Never get high on your own supply.

Modeling is useful but more in testing market assumptions. Like you build a model and true it up to consensus forecasts so that it’s generally equivalent. Then you start testing those assumptions for sensitivity, robustness, reasonability, etc.

also on the dcf note. many people actually incorporate a multiple at the very end. for a growth company for instance, some want to sell b4 the growth slows down so people just end it in like 3-5 years for example and apply a high multiple on the last year’s cash flow.

for a typical value company that buffett wants to invests in, he usually wants a company with predictable cash flows in the long run that will stand the test of time. so he usually doesnt incorporate an end multiple. The idea is that he wants to own it forever because he likes the business. that the co has an edge. and that no innovation will erode that edge.